The Banking System - Synthetic Economics

Note: If you are a new visitor to this blog, this may not be the kind of post that you were expecting, as it touches on some very specific economic theory. If so then you may want to skip to some of the other posts which are easier to follow ( I would recommend 'A Funny View of Wealth' as a starting point - it is long, but hopefully interesting). Alternatively, if you want to have your head spin, then read on....

I have had another interesting question from Lemming, and one which takes me out of my 'comfort zone'. The question is as follows:

'One thing I have yet to resolve, is the role of 'fractional reserve banking' in the operation of the markets. Why do we use it? Is it fundamental to capitalism? Is the idea that it is simply an efficient self-regulating mechanism? Or is it a system bankers have devised make themselves very rich? '

There is an excellent introduction to this subject on Wikipedia that can be found here. You will need to read this in order for what I write later to make sense. I'm afraid that it is not particularly easy reading, but I hope that when combined with what I am writing later, it will make some sense. I guess that this is a question that has been raised following my discussion of banking regulation. The whole idea of fractional reserve banking can sometimes get your head spinning. How can you create money from nothing?

Instead of giving a long discussion of how it works, which is any case covered in the Wikipedia article, I would like to describe a very weird idea that helps illuminate the Alice in Wonderland of what I might describe as synthetic economics.

Right now there is a virtual/synthetic world called 'Second Life' (the website is here). This synthetic world allows people to have a 'second life' using avatars (computer generated representations of people). The curious thing about this is that they have an economy in this virtual world, and people are even earning their living there. People design and sell virtual clothing for people to use for their avatars, design buildings and so forth. The most curious part is that they have their own currency, the Linden Dollar.

So how does this economy work? The starting point for the economy is that the company that owns Second Life, Linden Lab, makes money through the sale of virtual land in their world. In order to buy land, you need Linden dollars. As such, if you are new to Linden Lab, you need to exchange 'real currency' for Linden dollars. Alternatively, you can go to work and design and sell something within this world for Linden Dollars. Second Life is not the only virtual world that has a virtual economy.

What I will now do, is paste in something I wrote on this subject a while ago. I'm afraid that the relevant part is towards the end, but this part will only make sense if you read the rest. It is rather academic, but stick with it. It will explain something very important about the question of fractional reserve banking.

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The Economics of Synthetic Worlds

The importance of the economics of activity in synthetic worlds first became apparent in a paper by Castronova (2001), an economist, who detailed a virtual economy with very real impacts on the real economy. His study showed that the synthetic world of Norrath, as part of the ‘Everquest’ game had created a currency with a $US exchange rate that exceeded the rate of the lira and Yen, and that Norrath’s GNP per capita exceeded that of India and China. One recent paper (Chein, 2006) gave the aggregated value of trading in property in synthetic worlds as being worth hundreds of millions of dollars annually, and it is likely that such trade will have grown since the paper was written (at least in line with the growth of participant numbers - ‘at least’ is used on the basis that, as more people become aware of the potential to use synthetic worlds to earn money, and greater the likelihood that individuals will be using synthetic worlds in this way).

Lederman (2007) explores why it is that such games have such an economic basis. For worlds, such as ‘World of Warcraft’, she points to the utility of the items in achieving the quests that are a major part of the game, and their utility in helping to achieve higher levels for their characters (to this explanation, Lederman should also add that high value items also confer status on the holder, on the basis that they are (in this case false) representations of accomplishment). Whilst this appears to contradict the purpose of the game, where enjoyment is derived in part from ‘achievement’ in the game, she points out that there are circumstances in which individual players might want to speed the process, such as keeping up with more friends who are more accomplished players. By contrast some synthetic worlds, such as ‘Second Life’, offer an environment that is explicitly commercial, such that many of the activities in the world explicitly require money, whether generated within the world or from without. In this circumstance it is inevitable that the world will develop an economic base.

One of the researchers who have started to consider the economics of synthetic worlds is Malaby (2006). He details the case of a person who developed a game called Tringo, within the environment of ‘Second Life’, which then became a sensation within the world. He points out that this has created a situation where a virtual person created a virtual game that was then sold to virtual people. However, rather than being startling, this is the very foundation of the ‘Second Life’ experience. The logical outcome of this idea of virtual items being virtually made and sold is detailed by Chin (2007), who notes that one individual had achieved $US millionaire status through becoming the ‘Virtual Donald Trump’ (p 1306). Other participants are giving up their ‘real’ world jobs and making ‘Second Life’ the home of a second career. In 2005 there were already ten individuals who were earning over $US 250,000 salaries from ‘Second Life’, and the ‘Second Life’ world hosted at least 7000 profitable businesses. There have already been several reports of real world businesses that are exploiting the economics of synthetic worlds, such as an individual who established a company in the real world, in which Chinese artists and engineers have been employed to build new virtual objects within ‘Second Life’, and more recently ‘Entropia’ (Hendaoui et al, 2008).

It is not only individuals that are undertaking commercial activity within ‘Second Life’, but also corporations, notable examples of which are Nissan, who purchased and island in ‘Second Life’ to create a driving course, and created a car ‘vending machine’ as a promotion. Other companies experimenting with ‘Second Life’ as a promotional channel are Nike, Reebok, Amazon and American Apparel (New York Times, 2006). Whilst initial forays into ‘Second Life’ by real world businesses have had mixed results, it is likely that, with experience, companies will find ways to successfully exploit this new commercial space, at which time the economic importance of synthetic worlds will further increase.

Malaby has considered some of the implications of such economic developments. He notes, for example, that commodity value is transformed in Synthetic Worlds. Once the code for an item, or service, is developed, then everything has the potential to be a commodity. The way in which morpegs have tried to overcome this is through control, in this case by maintaining scarcity through governance of the synthetic worlds. In addition to scarcity, another key part of the value of marketable items in such worlds also lies in the utility of use value of the items, such as their provision of social capital, which in turn often requires scarcity. To illustrate this point Malaby uses the real world example of a baseball card, where the value is culturally derived and the value is further defined by relative scarcity.

Castronova (2007) also asks some interesting questions about the economics of synthetic worlds. He takes the example of an individual who is building products within Second Life, and earning $US convertible money from doing so. As such he proposes that the individual’s activity in Second Life should also be regarded as a part of the ‘real’ economy and be included in GDP, asking the question of whether activity in the synthetic worlds should be taxed. Inevitably, this question raises further questions, such as the question of whether a person who builds themselves a house in ‘Second Life’ for their own use should be taxed on the property. Has the individual generated an asset? If the house appreciates in value, should it be liable for capital gains tax, or other duties. The house has a potential real $US value so the building of the house represents productive activity. How do the ‘real world’ institutions such as law and government deal with such a situation?

Lederman attempts to answer some of these questions, taking up the issue of taxation of synthetic worlds in her paper ‘”Stranger than Fiction”: Taxing Virtual Worlds’ (2007). She points out that, in the US, the Internal Revenue Service is already aware of the potential for taxation of earnings in synthetic worlds. She examines the US tax code in relation to synthetic worlds, choosing to analyse environments like ‘World of Warcraft’ and ‘Second Life’ as separate (but related) cases.

For the former, she considers the case of ‘loot drops’, which are the primary source of ‘earning’ items of value. Having dismissed the status of the End User Licence Agreements and accepted that the participants ‘own’ their synthetic world property, she goes on to consider whether these loot drops are liable for taxation. She commences by firmly dismissing the idea that loot drops might be imputed income (which is that they are market-price equivalents of non-market activity - an example being a home made table), arguing that they are not self generated, but require the activity of a third party (the world developer). Another possible source of taxation she proposes is that the loot drop might have equivalence to a windfall, which are winnings or found items (she cites game show prizes as one example), all of which are subject to taxation. However, she argues that loot drops should not be treated as a windfall, as participants must invest substantial time and effort to attain them. Instead, she argues, the loot should be treated as a ‘taken’ item (an analogy being a fish caught by a professional fisherman), as it is neither a windfall, but neither is it a self-made item (it is made by the game). In this case, Lerman argues that such items are counted as inventory, and do not constitute income until disposed of.

There appear to be some problems with Lederman’s argument. First of all, a windfall such as a game show prize might require substantial effort, for example preparing for a quiz. As such, in both cases, equivalence can be shown. Both are described as games and both required prior effort to achieve the winnings. Another problem occurs with her idea that the item is ‘taken’ and is therefore counted as inventory. Normally, when loot is gained by a participant, they will quickly use it in one of three ways. Either it will be used by the player to continue playing, in which case it might be regarded as using retained earnings as investment capital (and therefore becomes accountable in tax considerations), or the player will exchange the loot for other items in the game (selling it to a merchant or making an exchange with another player) which would constitute barter (taxable under US law), or they will sell the item/s for real world currency to another player. In all three cases the player utilises the items, and does not retain them as inventory.

It appears that Lederman is ignoring the fact that what is being produced in these ‘games’, is no more or less real than a piece of software, a book, a movie, a personal shopper service, or even a package holiday. As an example, if an individual were to start to manufacture knitted jumpers, and used a system of barter to exchange them, then they would be liable for taxation. How would working towards earning a piece of armour in ‘World of Warcraft’, differ from producing goods for barter? In both cases the individuals have used tools to develop the item (note, the idea that you pay to use some synthetic worlds has an equivalence in this situation to leasing a machine for the knitting). As soon as the armour is exchanged in any way but as a gift, the person who has worked to gain the item has either engaged in barter, or engaged in trade. Lederman accepts this principle in player to player trade, but fails to recognise the other potential avenues for trade, such as with a Non-Player Character, or the fact that the item is a tool to further advance in the world, thereby creating opportunity for further ‘loot’.

Another problem with Lederman’s argument is her view that the income can not be viewed as imputed income. One way of looking at the question would be to view the synthetic world as facilitating software, as equivalent to Microsoft Word. If a consultant types a report in Word, there is no question that the output would be taxable when the consultant is paid for their service, as the software is not treated as a third party but as a tool. In both cases software facilitates the realisation of the item, and in both cases the item has real value that is earned by the user. This renders the argument that the drop is not imputed income to be false, as it relies on the idea that the developers are a third party, rather than the reality that their software facilitates the earning. As a note, as Lederman points out, one of the primary problems in taxing imputed income is that it is so hard to identify and value. In the case of synthetic worlds, such items can be readily traced, and the market value can be relatively easily ascertained.

In the case of ‘Second Life’ Lederman takes a different approach. In doing so, she manages to tie herself in some knots. She correctly acknowledges that in ‘Second Life’ property is recognised (albeit in an unclear way) by the developer, implying (in the way that her argument is structured) that this creates a distinction between worlds such as ‘Second Life’ and ‘World of Warcraft’. However, this is irrelevant, as her previous arguments were based upon the assumption of property rights in the other synthetic worlds. She commences her analysis of ‘Second Life’ with a problematic argument, suggesting that exchange of property for Linden Dollars constitutes an ‘exchange’, even though the seller obtained no cash [by which she means ‘real’ cash]. In this case she sees that the transaction can be counted as barter, which is a perfectly reasonable position. However, in making this argument, the problem arises as to how Linden Dollars differ from Gold, Silver, and Copper pieces in ‘World of Warcraft’. In ‘World of Warcraft’ it is a normal part of the game to visit a merchant (NPC) and exchange items for this local currency. As such, as suggested earlier, barter has taken place, and it is not clear how Lederman can make any distinction between the two situations.

From the above example, it seems that there is a fundamental problem in Lederman’s perceptions. One problem is that it appears that she is unable to overcome the idea that it is possible to obtain income from pleasurable pursuits (despite the evidence of professional sportspeople, for example). This can be seen in the difference in the treatment of different synthetic world currencies. The other problem appears to be that she is unable to grasp the idea that virtual items really are equivalent to real items, despite her assertion to the contrary early on in her paper. Again, this is illustrated in her failure to understand the nature of the currencies of synthetic worlds.

Whilst it is tempting to view these currencies as part of the play, even as a gimmick, and not as ‘serious’ currencies, Malaby (2007) makes an interesting comparison. He points out that the Euro was a purely virtual currency before it became a physical currency (i.e. before it became notes and coins that could be utilised in day to day commerce). The whole purpose of this virtual rollout was to establish trust in the currency before it was made a physical currency. Equally, since the abolition of the Gold Standard modern currencies can not be redeemed against fixed specie of a commodity. Therefore, if we view any currency in the modern world, there is no way to give a real value to a currency except through purely subjective belief in what the value might be (an idea amply illustrated in the recent devaluations of the $US). On this basis, there is no reason to view the $Linden in a different light, as it is no more or less virtual, and the value of the currency is determined subjectively by similar sentiments to a ‘real’ currency.

The idea of synthetic world currencies also raises some interesting questions over and above the question of equivalence with real world currency. Malaby raises the question of what institution is underwriting the currencies of synthetic worlds, though unfortunately fails to address this question. At the time of his writing, he was probably unaware of the run on a virtual bank in Second Life, inspired in part by financial troubles in the real world (Economist, August 2007).

In the case of ‘Second Life’ the obvious answer to the underwriting question is that Linden Lab, as the owner and equivalent of the government of ‘Second Life’, is the underwriter of the currency. If this is accepted then it becomes clear that Linden Lab has taken a significant financial and governance responsibility. For example, opening too many islands too fast would precipitate a dramatic fall in property prices. Also, if they were to allow ‘pirating’ of virtual goods, destruction of goods, or general lawlessness, then all of these would have an impact on the trust in the $Linden, and the currency would be at risk of devaluation or collapse. In effect the primary role of Linden Labs in their governance is the protection of property rights within ‘Second Life’, a role with obvious parallels to real world government. However, they also need to ensure the maintenance of scarcity, in the context of virtually zero marginal cost for reproduction of all commodities and resources, a unique feature of synthetic worlds, creating very strong obligations to protect intellectual property rights.

Linden Lab appears to be aware of the importance in their role of currency stabilisation, and ‘uses a set of monetary instruments, allowing it to inject or mop up liquidity. It also intervenes on […] LindeX, which even features circuit breakers if trading gets too frantic’ (Economist, August 2007).

Once it is accepted that virtual property has real value, a greater question is ‘what happens if ‘Linden Lab’ or any other developer, ends their world whilst there are still assets inside the world? For example, what would happen to the Australian investor who purchased an island in ‘Project Entropia’ for GB£13,700 (Chein, 2006), or to the ‘Donald Trump’ of ‘Second Life’ in the event that servers for their respective worlds were switched off? In this event the losses to the individuals is very real, and would undoubtedly lead to real world litigation.

This idea of maintaining scarcity may not be the only necessity in the governance of synthetic world economies; there is also arguably a need for maintenance of synthetic world stability. Bartle gives a hypothetical example of a game where there is a special sword which a person has purchased for $US500. If the developers decide that the sword is too powerful, and is unbalancing the game, they would (under current practice) be likely to lower the power of the sword to restore balance to the game. In doing so the player who purchased the sword would be disadvantaged. Bartle makes the point that nearly all changes within a game have the potential to advantage or disadvantage each of the participants. However, in this case the individual would have, through no fault of his own, and through no fault of the seller, overpaid for the now reduced power sword. As such the participant might feel a need to seek legal means for restitution from the developer.

Bartle, who has the perspective of a game developer, points out that allowing such restitution would be a bad thing for the game/world, as it would remove the freedom of the designer to alter the game. Referring to the potential to seek legal recourse, he argues that, even were it to be left to judges to decide on the reasonableness of a change, it would not be possible to do so, any more than asking a judge to measure the ‘reasonableness’ of a portrait. This view implies that the developers are in the position of benevolent dictatorship, or as Chein (2006 expresses it; ‘the administrators of games are necessarily “God” for all practical purposes, able to control every aspect of the game world to the point of deleting avatars in order to maintain a balanced play area’ (p1066).

The inspiration for this view could be lifted straight from ‘Leviathan’, in which Hobbes proposes that effective governance requires absolute authority. The view of Bartle highlights the fundamental problem that developers have in understanding exactly what they have created. The worlds that they develop cease to be only under their own governance, once the players enter the world. As is discussed in the section on synthetic world law, once a player enters a game, they also bring the law and expectations derived from the real world with them. As another example, Mnookin (1996) discusses law in LamdaMOO, noting that, in disputes between participants, individuals would often introduce legal principles from the real world into the debate, despite the community having its own system of ‘law’. As such, individuals will expected to be treated fairly within the world based upon external norms, and having your sword devalued by a ‘government’ with no compensation, however benign the government may claim to be, will not be considered fair treatment by the individuals, and possibly by the synthetic world community. It will clearly be a dilemma for developers to balance overall game play against the (often originally unintended) economic nature of their creations, a point understood by Chein (2006) in his thought experiment on theft of virtual property.

This brief review only touches on some of the economic questions that are being raised by the development of synthetic worlds. A brief review of a small part of the literature reveals that people are still struggling with many of the implications of virtual economics, in particular in the recognition that virtual property has equivalence to real property. A simple illustration of this confusion would be that it would be a very curious point of view to differentiate between an individual who, as a ‘labour of love’, writes an electronic book and a person labouring towards achieving a character at level 50 in a morpeg. However, in the first case few would argue that the sales of the book should be viewed as a part of the normal economy, but few would suggest that the labour of the individual creating the character is part of the normal economy (despite the real value that is created). There appears to be no rational reason for this and it is therefore unlikely that the differentiation will be allowed to persist.

At the moment the economies of synthetic worlds are still developing but the interest of the US tax authorities’ interest is indicative of their potential importance. Within the context of the rapid and dramatic expansion of the numbers of people using synthetic worlds, and the amount of time that they are spending inside them, the virtual economy will soon be having some profound effects on the real economy. Furthermore, it is likely that hybrids between types of games will emerge, games which will merge the ideas of ‘Second Life’ with the ideas to be found in games such as ‘Everquest’. If this occurs, not only will the boundaries between the real and synthetic economic worlds have blurred, but also the boundaries between work and play. This blurring will potentially serve to heighten confusion over what constitutes the ‘real’ economy.

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An apology - I do not have the references to hand that I have made in the text above.

The reason that I have included this is that it illustrates something that is vital to grasp. The Linden Dollar is absolutely no different from the $US or the £GB. In all cases their value rests entirely on confidence. In other words, this is a very long winded way of demonstrating that the modern economy is built on nothing more than confidence. It is no more real than the world of Second Life, and that includes money.

If we look at fractional reserve banking, we see the same thing. The entire system is built on confidence. It is the belief that we can redeem our money, if we so wish. It is built on the belief that, when we do redeem our money, it will have retained at least most of its value for exchange with goods or services. More than that, it assumes that it has a value at all. Just as with the Linden Dollar, there is nothing really there to back it up except our collective belief that £1 will be able to be exchanged for something which we value. The person who accepts our £1 must also believe that it has value.

If we were to imagine that Linden Labs suddenly made available large amounts of land, they would undermine the confidence in their currency, and there would be a run on the currency as everyone rushed to convert it to another currency that would retain its value. This is because the value of the currency is tied to scarcity, in this case scarcity controlled by Linden Lab.

If you have read the Wikipedia article, I think you will grasp what I am pointing at here.

Returning to the original question, is fractional reserve banking a good thing? That depends largely on whether you believe that it is possible to maintain confidence in the system. My argument would be that this confidence is currently being tested. There has already been a bank run in the UK with Northern Rock, and a run on IndyMac in the USA (see here for the story). The whole system relies on confidence. That confidence relies on the belief that the banks have invested the money that they hold wisely, and that the value of the assets that they hold has retained sufficient value for the money deposited to be returned.

The good side of the system is that it allows for rapid economic expansion, but the downside is that there is a fragility, and that the fragility is built upon the foundations of the system - confidence. The whole system is no more real than the confidence in the Linden Dollar, and the economy of the world is no more real than the economy of Second Life. It is all built upon belief in the value of currencies that have no real value, except what we subjectively give them.

Scary, huh? Is your head spinning? The foundation of modern economies is our subjective belief that the bank which holds our money will safeguard the value of that money, and that the money will retain a similar value in exchange tomorrow as it does today. In other words the foundations of a modern economy is entirely in each and every one of us, in our heads. This is the foundation of fractional reserve banking.

I hope that I have helped answer your question, albeit in a very circuitous way.